China's Iron Ore Strategy Will Backfire

With talks between China's high-cost steel industry and the global miners moving from the commercial to the political realm, we believe the endgame will be a mate for the miners with the current annual benchmark system evolving into a quarterly "virtual spot," up 90%-100% vs. last year.

The Chinese Ministry of Commerce has agreed to step into the fray and will "take moves to support Chinese steel mills, including adopting necessary trade measures." We believe that political measures will be useless as they have been in the past.

Australia stands firm, voicing strong opposition to any government involvement.

Vale ( VALE) has had little to say, but we're reminded of a quote from the company's chief negotiator that was published in The Wall Street Journal in November 2005: "The colonial period, when some nations defined the prices at which other nations had to sell their products, is over; price increases are not a matter of speech nor weapons; but a market issue."

A China Premium -- Bullying Behavior Backfires

We continue to believe that the Chinese will end up paying some kind of price premium for two reasons.

First, the Chinese position that as the world's largest buyer it should pay less than others has proven futile for years.

It's our view that given the difficulty for iron ore customers to easily switch vendors, the seaborne ore trade should be viewed as a "reverse commodity" where the more ore a buyer needs, the more the buyer has to pay up for that.

Secondly, it's no longer a secret that the cost of doing business in China is clearly higher than other regions; last summer it was reported that Rio Tinto ( RTP) had requested some $9 billion in compensation for costs associated with the Chinese iron ore "negotiating strategy."

High-Cost China Will Become Higher-Cost China?

With some 60% of global steelmaking capacity and rising, China's steel production has grown at nearly 20% per year for most of this decade.

This growth is testament to the nation's strength and wisdom in industrial engineering; the success and stature of the Chinese steel industry is nothing short of miraculous.

But this growth has come at a meaningful price: China is the world's highest-cost steelmaker, and with iron prices surging in the coming year, the cost differential will continue to widen. So we suspect that one outcome of the current iron ore contract will be to accelerate the shakeout of what Beijing calls its "backwards and polluting mills." The more pressure on high-cost China, the higher steel prices will rise.

Impact on Steelmakers

Higher iron ore prices are bullish for the domestic steelmakers and Arcelor Mittal ( MT) due to the fact that these lower-cost players are either more integrated than their global peers -- or have access to local ore bodies or scrap at a lower cost -- so that the higher global iron ore prices go, the more competitive advantage the domestic players have.

Michelle Galanter Applebaum spent more than 20 years as a managing director at Salomon Brothers in New York and was the No. 1-rated steel analyst from 1988-2003, according to Institutional Investor magazine. In 2003, Ms. Applebaum formed Steel Market Intelligence, a 5-person Chicago-based equity research boutique providing advisory services to institutional investors. In addition to publishing 10-15 reports/week, Ms. Applebaum sponsors numerous CEO-level meetings for her investor clients during the year. She is regularly quoted on Bloomberg, Dow Jones, The New York Times and makes frequent appearances on CNBC and other news programs. Ms. Applebaum lives near Chicago with her husband, visiting children and 2 dogs.